what is the weighted average cost of capital

The weighted average cost of capital, or WACC, is the blended rate a company pays for all its capital — equity and debt combined — weighted by how much of each it uses. Equity has a cost (the return shareholders require, from CAPM) and debt has a cost (the interest rate, reduced by its tax deductibility), and WACC mixes them in proportion to their share of the capital. It represents the minimum return the company must earn on its investments to satisfy everyone who funded it, which is why it doubles as the discount rate in a valuation and the hurdle for new projects.

how do you calculate wacc

WACC is the equity weight times the cost of equity, plus the debt weight times the after-tax cost of debt. The weights are each source’s share of total capital, and the debt cost is multiplied by one minus the tax rate to reflect that interest is tax-deductible. For example, a company that is 70% equity at a 14% cost of equity and 30% debt at a 9% pre-tax cost with a 25% tax rate has a WACC of 0.7 × 14% + 0.3 × 9% × 0.75 = 11.8%. That 11.8% is the blended rate its capital demands.

why is debt cheaper than equity in wacc

Debt is cheaper for two reasons. First, debt holders take less risk than shareholders — they are paid before equity and have contractual claims — so they demand a lower return. Second, interest on debt is tax-deductible, so the government effectively subsidises part of the cost; a 9% interest rate at a 25% tax rate costs the company only 6.75% after tax. Equity has neither advantage: dividends are not deductible and shareholders bear the residual risk, so they require more. This is why adding some debt can lower a company’s WACC.

how does capital structure affect wacc

Because debt is cheaper than equity, replacing some equity with debt initially lowers WACC — the reason companies use leverage at all. But this only goes so far: as debt rises, the risk of financial distress climbs, so both lenders and shareholders start demanding higher returns, pushing the costs of debt and equity back up. WACC therefore tends to fall, reach a minimum at some optimal mix, then rise again as too much debt makes the whole company riskier. Finding that balance is the essence of capital-structure decisions.

What is WACC and how to calculate it

A company raises money from two kinds of financier — shareholders and lenders — and each demands a different return. WACC, the weighted average cost of capital, blends those two costs into a single number: the rate the company as a whole must beat to be worth funding. It is the hurdle behind every investment decision and the discount rate behind every valuation.

Blending the cost of equity and debt

WACC weights each source by its share of total capital: equity weight × cost of equity + debt weight × after-tax cost of debt. The cost of equity comes from CAPM; the cost of debt is the interest rate, cut by the tax shield because interest is deductible. The result is the minimum return the business must earn on its assets to keep both its shareholders and its lenders satisfied — no more, no less.

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Set the equity and debt values and their costs, and watch the WACC — then add debt and see it fall (the tax shield), before you push leverage far enough that the risk would push costs back up.

Worked example

A 70/30 capital structure

Tax rate 25%

Equity: 70% at 14%Cost of equity from CAPM0.7 × 14% = 9.8%

Debt: 30% at 9%Interest is deductibleAfter tax: 9% × 0.75 = 6.75%

Debt contributionWeighted0.3 × 6.75% = 2.03%

WACCThe blended hurdle9.8% + 2.03% = 11.8%

UsesBeat it or destroy valueDCF discount rate; project hurdle

The blended 11.8% is what this company’s capital costs. Any investment it makes must earn more than 11.8% to create value; anything less destroys it. It is also the rate you would discount its free cash flows at in a DCF, which is why the ROIC-versus-cost-of-capital and DCF lessons both lean on this exact number.

Check yourself

A company is 70% equity (cost 14%) and 30% debt (pre-tax cost 9%), with a 25% tax rate. What is its WACC, and what does it represent?

Simple bhasha mein

Poori capital ka mila-jula daam

Company do jagah se paisa uthaati hai — shareholders (equity) aur lenders (debt) — dono ka apna daam. WACC dono ka mila-jula rate hai, unke hisse ke hisaab se. Debt sasta: kam risk + interest pe tax bachat (9% × (1−25%) = 6.75%). 70% equity @14% + 30% debt @6.75% = ~11.8%. Yahi hurdle hai — isse zyada kamao toh value banti, kam toh doobti. DCF isi rate se discount karta hai. Par bahut zyada debt = distress risk = WACC wapas upar.

What to remember

WACC blends the cost of equity and after-tax cost of debt, weighted by each one’s share.
Debt is cheaper — lower risk plus a tax shield — so some leverage can lower WACC.
Too much debt raises distress risk and pushes both costs, and WACC, back up.
WACC is the DCF discount rate and the hurdle ROIC must beat to create value.
It is an estimate with a range; test valuations across a band of WACCs.

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Common questions

Short, direct answers to what people ask about this topic.

what is the weighted average cost of capital: The weighted average cost of capital, or WACC, is the blended rate a company pays for all its capital — equity and debt combined — weighted by how much of each it uses. Equity has a cost (the return shareholders require, from CAPM) and debt has a cost (the interest rate, reduced by its tax deductibility), and WACC mixes them in proportion to their share of the capital. It represents the minimum return the company must earn on its investments to satisfy everyone who funded it, which is why it doubles as the discount rate in a valuation and the hurdle for new projects.
how do you calculate wacc: WACC is the equity weight times the cost of equity, plus the debt weight times the after-tax cost of debt. The weights are each source’s share of total capital, and the debt cost is multiplied by one minus the tax rate to reflect that interest is tax-deductible. For example, a company that is 70% equity at a 14% cost of equity and 30% debt at a 9% pre-tax cost with a 25% tax rate has a WACC of 0.7 × 14% + 0.3 × 9% × 0.75 = 11.8%. That 11.8% is the blended rate its capital demands.
why is debt cheaper than equity in wacc: Debt is cheaper for two reasons. First, debt holders take less risk than shareholders — they are paid before equity and have contractual claims — so they demand a lower return. Second, interest on debt is tax-deductible, so the government effectively subsidises part of the cost; a 9% interest rate at a 25% tax rate costs the company only 6.75% after tax. Equity has neither advantage: dividends are not deductible and shareholders bear the residual risk, so they require more. This is why adding some debt can lower a company’s WACC.
how does capital structure affect wacc: Because debt is cheaper than equity, replacing some equity with debt initially lowers WACC — the reason companies use leverage at all. But this only goes so far: as debt rises, the risk of financial distress climbs, so both lenders and shareholders start demanding higher returns, pushing the costs of debt and equity back up. WACC therefore tends to fall, reach a minimum at some optimal mix, then rise again as too much debt makes the whole company riskier. Finding that balance is the essence of capital-structure decisions.

WACC: the blended cost every company must beat

Blending the cost of equity and debt

Common questions